The Engler Record on Taxes

A major point of contention in the governor’s race between John Engler and Howard Wolpe is how much taxes have been reduced or increased during the Engler administration, and whether tax cuts have been responsible. ThisAdvisor addresses these issues.

Introduction

Our best estimate is that state and local taxes in FY 1994–95 will be reduced by about $1.2 billion as a result of legislation enacted during the Engler administration.1 The net tax reduction, however, after accounting for higher federal income taxes due to loss of property and income tax deductions, is about $0.9 billion.

Much of this reduction is a result of the new school financing system, which cut net property taxes by about $2.9 billion and replaced a large share of this loss with state taxes. Several other tax and fee changes not related to school finance reform resulted in a net reduction in state revenue of $128 million, and the 1992 assessment freeze reduced property taxes by about $250 million (net of credits). (See Exhibit 1.)

The only increases legislated during the Engler administration, other than to replace the reduction in school property taxes, were an increase in the state markup for liquor (estimated to raise $32 million, but likely to raise less than $20 million due to a decline in consumption), and $85 million in fee increases (over the last four years).

This significant reduction in state and local revenues raises several important questions.

Are adequate revenues available to finance the new school aid fund and the state budget?

Who are the winners and losers?

Have these tax changes improved the Michigan tax structure?

What will be the effect on the state’s economy?

Revenue Adequacy

Adequate revenues will be available through FY 1995–96, due to strong revenue growth recently and the early collection of the replacement taxes, which took effect on May 1. Beyond that, revenue adequacy depends on the strength of the economy.

Exhibit 2 shows a scenario that assumes that economic growth will begin to slow in 1996. This forecast is based, in part, on cyclical trends in the motor vehicle industry. While we expect auto sales to increase in 1995 for the fourth consecutive year, there have never been five consecutive years of sales increases since World War II.

Under the scenario in Exhibit 2, revenues needed to finance the new school aid fund and the remainder of the state budget fall short by about $400 million in FY 1996–97; the school aid fund will need a $1.2 billion transfer from the general fund to achieve balance, leaving a shortfall in the general fund. While not an unmanageable problem, this would require reductions in the state budget (below a continuation level) or in school payments, or an increase in revenues. Despite concern about the state tax limit (imposed in 1978 by the Headlee amendment), our projections, as shown in Exhibit 3, indicate that there would be room to raise revenues by about $800 million in FY 1995–96.

Winners and Losers

Space does not allow for a comprehensive discussion of the winners and losers from the tax changes enacted in the past four years. It is clear, however, that the biggest winners are home-owners (particularly those who do not smoke or own a second home) who live in high millage school districts and do not qualify for the state property tax credit. Homeowners who fit this profile tend to live in suburban areas and earn more than $82,650 annually (the income limit for the state property tax credit). This group will also benefit from the reduction in the income tax rate. Partly offsetting the benefits to high-income taxpayers will be higher federal taxes due to the loss of deductions for property taxes and state income taxes.

The effect on senior citizens is mixed. The majority of seniors will not receive much property tax relief, because they lose one dollar of state tax credits for every dollar of property tax relief. About 25 percent of senior homeowners, however, are constrained by the $1,200 limit on the state property tax credit and will benefit from the property tax cut. In addition, many seniors will benefit from the increase in the state income tax pension exemption, and their heirs will benefit from the repeal of the inheritance tax. The sales tax will not be a major burden for most seniors, as food and drugs are fully exempt and residential utilities are exempt from the increase, and most seniors do not buy as many big ticket items as younger consumers.

The group that loses is renters, about 25 percent of the population, as they receive no direct property tax relief but will pay the higher sales tax. An increase in the state renter credit will help, but it is relatively small.

Businesses receive a small net reduction in property taxes and some tax relief due to the changes in the single business tax (SBT), with most of the SBT relief going to small businesses.

Michigan Tax Structure

On balance, the changes have improved the Michigan tax structure. First, the balance of the tax system is improved. Prior to passage of the new school financing package, Michigan property taxes were about 35 percent above the national average, and the sales tax was about one-third below the national average. Now property taxes are about 9 percent below the national average and the sales tax is right at the national average. Second, taxpayer acceptance of the tax system will be improved with lower property taxes and a cap on assessments. The sales tax increase is less noticeable and more acceptable to most taxpayers.

On the negative side, the new replacement revenues will grow slightly slower than the property tax and be a little more unstable. Also, some of the changes, such as the elimination of the inheritance tax, the reduction in the SBT, and the increase in the pension exemption, do little to improve the overall tax system while substantially reducing revenue.

The pension exemption ($30,000 for a single filer and $60,000 for a joint filer) is particularly inequitable in that a high-income retired person will pay considerably less in state income taxes than a working person with a much lower income. We also question whether the reduction in the income tax rate from 4.6 percent to 4.4 percent (as of May 1, 1994) is worth the $260 million revenue loss. This amounts to only $3 a paycheck for a person earning $40,000 and will hardly be noticed. The money could have been better used to fund an earned income tax credit in Michigan (tied to the federal credit), an increase the income tax exemption, or more property tax relief, particularly for renters.

The Michigan Economy

Governor Engler and his advisors believe that tax reductions will directly stimulate economic growth in Michigan, although there is little evidence to support that view. Tax cuts at the state level do not put more money in circulation, as they transfer money from government spending to private spending, which may be politically expedient but does not produce more economic activity.

The recent tax reductions, however, can indirectly benefit the economy in two ways. First, reducing the overall tax burden in Michigan could make the state a more attractive location for business, although few jobs are created by firms moving from out of state. Progress has been made in reducing Michigan’s relative tax burden. In FY 1985–86 state and local taxes were 17.5 percent of personal income, 9.4 percent above the national average and 14th highest in the nation. In FY 1991–92 (latest data available) state and local taxes were 16.8 percent of personal income, 2.4 percent above the national average and 19th highest in the nation. Michigan should be at or below the national average when FY 1994–95 data become available.

Second, the sales tax will have a less negative effect on capital than the property tax, which should stimulate more business investment in Michigan. On balance, shifting some of the property tax burden to the sales tax should have a small positive effect on the economy.

Despite claims to the contrary, the current economic recovery is far less the result of state tax policies (the majority of cuts have come too recently to have any perceptible effect) than of the robust performance of the motor vehicle industry, which is in a cyclical upswing and has been a major beneficiary of national and international economic developments, such as the decline in the value of the dollar against the Japanese yen. (Next week’s Advisor will analyze recent job growth in Michigan.)

Conclusion

In the past four years the governor and the legislature have enacted the largest net tax cuts in memory. The effect of these reductions on the economy and the state budget have yet to be determined. Our view is that, while some of the reductions have been unnecessary, on balance the result has been an improvement in the tax structure without major damage to state services, although some human service areas have clearly been affected.

Our concern is that we are not adequately planning for the next inevitable downturn in the economy. A large balance is being built up in the Budget Stabilization Fund (BSF)—more than $700 million at the end of FY 1993–94—but this will all be needed to fund the new school aid formula. Even this large amount will be insufficient and will provide no protection for the remainder of the state budget. As we have said before, we believe that the recent cuts in the SBT and income tax (pension exemption) were unwise and that this $155 million should have been transferred to the BSF.

Michigan has gone through considerable pain to reach a position of fiscal stability. We must recognize that the good times will not last forever and take steps to consolidate our gains so that the next downturn in the economy will not undo all the progress that has been made.

1FY 1994–95 taxes will be about $0.95 billion lower due to the tax changes during the past years. In addition, the 1992 property tax freeze resulted in a onetime tax cut of $250 million (net of credits).